Lessons of Enron

Enron Lesson No. 3: Conflict of Interest

July 19, 2011

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Many of Enron's conflicts of interests started with its board of directors, shown above. The board had 17 members in 2000.

From senior management to its board of directors, Enron flouted even elementary conflict-of-interest standards and as a result conflict of interest is lesson No. 3 in CreditPulse's lessons of Enron. Several directors did business with Enron.

"Setting aside the accounting, idea of a venture entity managed by CFO is terrible from a business point of view. Conflicts of interest galore. Why would any director in his or her right mind ever approve such a scheme?" So wrote Benjamin Neuhausen, a member of the elite Professional Standards Group at Arthur Andersen, in May 1999 after learning of Andrew Fastow's plan to setup a private equity fund that would invest in Enron's deals, according to the book The Smartest Guys In The Room, the authoritative book on Enron written in 2003 by Bethany McLean and Peter Elkind.

Conflict of interest is lesson No. 3 in CreditPulse's lessons of Enron because the lack of oversight and control that got the company into so much trouble were often the direct result of conflicting interests from various levels of company management all the way to its board of directors, according to information obtained in the book and other sources. Conflict of interest occurrs when the interests of an individual or organization are at odds with the interests or motivations of another party that the same individual or organization is assigned to safeguard. Over the years, there have been many examples of conflicts of interests and actions taken to avoid them:

In 2001, Henry Blodget, a former Merrill Lynch securities analyst, became a lightning rod for critics of conflicts involving Wall Street analysts when it was revealed that he mislead investors by making public recommendations on companies that conflicted with the private recommendations to his clients. The bursting of the internet bubble in 2000 exposed a common practice in which Wall Street analysts were recommending the internet stocks of the same companies their firms did business with.

In 2008, credit ratings firms Standard & Poors and Moody's came under fire for failing to downgrade the credit ratings of some of the very companies they did business with. Moody's, CEO Raymond McDaniel even admitted that his firm's push to increase profits posed a "risk" to the quality of the ratings process, according to an internal document released by a Congressional investigative committee, as reported by the Wall Street Journal on October 23, 2008.

Traditionally, both individuals and companies have gone to great lengths to avoid even the appearance of a conflict of interest such as in 2001 when Harvey Pitt, President George W. Bush's selection to head the Securities and Exchange Commission (SEC), promptly announced he would recuse himself from cases involving the clients of the law firm that was his former employer.

In February 1990, Ernst & Young dropped PepsiCo as an audit client in order to avoid the possibility of a conflict of interest with its other client Coca-Cola. "We chose not to stand for re-election for the 1990 audit of PepsiCo because we understood Coca-Cola's concerns about full and open communications with us as auditors of both companies," said Morton Meyerson, director of public communications for Ernst & Young, as reported by the WSJ.

But, as was its custom, Enron chose to flout traditional standards of professional conduct rather than follow them. Conflicts of interest often existed between Enron and the myriad of special purpose entities (SPEs) that were setup for the expressed purpose of hiding debt and supplementing its poor operating cash flow. It's audit firm, Arthur Andersen, continued to peform internal audit and consulting services while also providing an external audit, in effect, auditing itself.

Conflicts existed within spin-offs such as the case with EPP, a publically-held spin off that would purchase assets from Enron so the company could book the sale of those assets as profits. EPP was supposed to be a separate company but after entering into a cost sharing agreement with Enron, EPP's accountants were basically working for Enron, according to the book.

Departmental integrity within the company was compromised by conflicts of interest. Enron's various deal makers, or sales people, had the right to edit the draft comments made by the company's risk assessment and control (RAC) department, an area set up to analyze and control the risks of Enron's complex deals.

Conflicts even existed on Enron's Board of Directors. From 1991 to 2000, Enron paid Board member John A. Urquhart for his consulting services. In 2000, he was paid $493,914, according to a report by the House Governmental Affairs Committee. Lord John Wakeham was a long-time consultant for Enron. Kenneth Lay and his wife donated nearly $600,000 and pledged $1.5 million to the MD Andersen Cancer Center for which two of Enron's Board members were affiliated (see accompanying list).

But the gravest example, even by Enron's standards, of conflicts of interest was the plan set in motion by Andrew Fastow to setup and manage his own private equity funds, known as LJM (the initials of his wife and two children), while serving as CFO. Fastow would now be serving two masters each with completely different obejctives.